The 2007-2008 financial crisis: Is there evidence of disaster myopia?

The disaster myopia hypothesis is a theoretical argument that may explain why crises are a recurrent event. Under very optimistic circumstances, investors disregard any relevant information concerning the increasing degree of risk. Agents' propensity to underestimate the probability of adverse outcomes from the distant past increases the longer the period since that event occurred and at some point the subjective probability attached to this event reaches zero. This risky behaviour may contribute to the formation of a bubble that bursts into a crisis. This paper tests whether there is evidence of disaster myopia during the recent episode of financial crisis in the banking sector. Its contribution is twofold. First, it shows that the 2007 financial crisis exhibits disaster myopia in the banking sector. And second, it identifies macro and specific determinant variables in banks' risk taking since the beginning of the years 2000.